23 July 2014|
Turn on CNBC right now, and it won’t take long for M&A news to show up. According to a recent report by Thomson Reuters, global M&A activity was up 73% in the first half of 2014 compared to the first half of 2013, which was the strongest first half gain since 1998. The healthcare sector led the markets in total deal value, comprising of 18% of all M&A deals. Out of the top 15 announced deals in the last six months, seven were in the healthcare sector. Deal news such as Pfizer’s attempted acquisition of AstraZeneca, Medtronic’s acquisition of Covidien, Allergan’s attempt to hold off Valeant, and AbbVie’s takeover of Shire have taken over recent financial headlines.
This trend is no coincidence, as there are three key factors behind the continuing rise in healthcare deal volume. There is an ongoing shift in pharmaceutical and biotech corporate strategy, firms are cashing in on the benefits offered by tax inversions, and U.S. equities are at an all-time high while interest rates still remain low.
The average cost of developing a new drug has skyrocketed from $1.1 billion in the late 1990’s to over $5 billion in 2013. This increased investment has forced drugmakers to focus on more targeted illnesses, especially those such as oncology, immunotherapies, and anti-infectives, which don’t yet have effective treatments on the market.
R&D into these tougher ailments has traditionally been done by smaller biotechs, which place all their chips into a few treatments with huge financial upside and risk. Larger pharmaceutical companies, which have traditionally been publicly-held, tended to invest in treatments that had a larger potential market, and more scientific research to minimize the risk of clinical trial failure. These firms, known in the industry as “Big Pharma,” would often acquire smaller biotechs only after a successful track record had been established.
Recently, more and more pharmaceutical firms have been acquiring biotechs that have promising pipelines, but may not have necessarily passed any phase III trials yet. They are taking this risk due to the significant impact that patent cliffs are having on top-line revenue for Big Pharma, and the excess amounts of cash that these firms are sitting on from the high profit margins and cash flow in the industry.
Conversely, smaller biotechs have a much tougher time raising cash, with many biotechs still remaining profitless since inception, so they welcome the increased cash flow and synergies that come with the resources of a big pharmaceutical firm.
Another factor in these recent healthcare deals, which is less relevant to small biotechs, is the tax inversion benefits that U.S. pharmaceutical companies receive by acquiring or merging with a company based in countries such as the U.K., Ireland, and the Netherlands, where corporate tax rates are significantly lower.
There has been talk amongst U.S. lawmakers to introduce legislation aimed at companies seeking an inversion, which may have led to a rise in recent deals in fear of losing this window of opportunity. Just last week, U.S. Treasury secretary Jack Lew urged Congress to crack down on inversions, calling for a need in “economic patriotism.” In my opinion, there is nothing unpatriotic about a company in the capitalistic U.S. economy strategically re-incorporating in foreign domiciles to save billions in annual tax expenses.
In terms of corporate strategy, inversions are a no-brainer as companies with business locations in the U.S. still enjoy intellectual property protection, government and private support for research and development, and the investment climate and infrastructure of the U.S, while paying less in taxes.
I don’t expect any measure aimed at putting restrictions on inversions to succeed in Congress, but we could certainly see legislation that would restructure U.S. corporate tax laws to be more business-friendly, given that the 35% corporate tax rate in the U.S. is the highest amongst developed nations.
Anyone who has been following the markets recently knows that both the S&P 500 and the Dow Jones Industrial Average are currently at or hovering near all time highs, adding to the 33% gain in the S&P in 2013.
The Fed’s quantitative easing program has kept interest rates relatively low compared to historic rates, with the 10-Year Treasury yield right around 2.50%. While yields aren’t as low as they were in 2012-2013, the last time the 10-Year yield hit 2.50% was back in the early 1950’s.
A notable figure is that in 2013, average earnings only went up 4%, far less than the market’s gain of 33%, indicating massive multiples expansion. The rise in equities makes deals more favorable to both acquirers and potential targets. Companies looking to acquire other firms can use the increased value of their stock to offer more equity percentage in a bid, reducing the amount of cash needed for the deal. Target companies will use their inflated stock prices to justify increased valuations. In addition, the cheap cost of debt due to low interest rates allows firms to raise more cash, if necessary, to fund a deal. The favorable market conditions actually apply to all M&A - not specifically healthcare, but nonetheless drives healthcare M&A.
Back to the healthcare sector, the S&P 500 Healthcare Index has been up 10% while the S&P 500 lags behind at 7% YTD. In addition, the 20 top Big Pharma firms have an average debt to capital ratio of 22.7% compared to 37% for the entire S&P 500. It’s no surprise that with this extra cash and lack of debt on their balance sheets, pharmaceutical companies are pursuing acquisitions as a way of effectively spending their earnings.
However, not all drugmakers are actively pursuing takeover deals. Firms such as Sanofi have stated their intentions to focus on organic growth, joined by Allergan and AstraZeneca, which have both expressed confidence in their ability to increase sales and profits without needing a strategic buyer.
Prior to Valeant’s bid for Allergan going hostile, Allergan CEO David Pyott accused Valeant of buying up smaller drugmakers and gutting them out by re-marketing existing products rather than focusing on organic growth through R&D. AstraZeneca also ensured shareholders that it was capable of increasing sales independently, as one of the reasons for rejecting Pfizer’s bid.
While I applaud these firms for their efforts in organic growth, focusing on the traditional route of internal pipeline development is no longer a viable option in today’s competitive environment. Drug R&D is more expensive than ever before, and Big Pharma with its patent cliffs can no longer take the financial risk of investing too much into their internal pipelines. Clinical trials can still be wildly unpredictable, and in many cases, it simply makes more economic sense to pay a premium to buy out a biotech that has already had success with its R&D.
Big Pharma will continue to acquire smaller biotechs for the foreseeable future, as these moves will make sense for both sides even when the market hits a downturn and interest rates rise. However, I expect inversion-driven acquisitions to die down after 2014. After all, these firms only need to re-incorporate once.
Pressure is also mounting on Washington to take action against tax inversions, and after this mid-term election cycle, we could see legislation making inversions more difficult, or removing any incentive for firms to leave the U.S. in the first place. Any Big Pharma that is seeking a more tax-friendly corporate environment through M&A has already announced such a deal, or most likely has a deal in the works.